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The Reference Dependence

There is an example that also challenges rational choice models. For this example imagine that you are a cabdriver in New York City.

Would one work longer hours on rainy days?

Within each days of 12 hour shifts you can work as much or as little as you like but some days will be better than others, on rainy days for example the demand for cabs is much greater than on sunny days.

Rational choice models make a prediction familiar to any labor economist: temporary increases in wages should lead to longer working hours while temporary decreases in wages should lead to shorter working hours.

If you are a cabdriver you should work longer on rainy days where you are earning more, but less on sunny days where you are earning less. But would you do that?

Suppose your four hours in your daily shift and you’ve been busy with high dollar fares the entire time, you already earned as much as you typically earn in an entire day. Do you keep driving throughout the shift or do you leave for home early satisfied that you made your day’s target?

The reference dependence

Economists analyze exactly this situation and found that New York cabdrivers work less when they’re earning more per hour and they work more when they’re earning less per hour.

Does this matter for their incomes? Yes! If the same drivers had simply work longer hours and good days and shorter hours on bad days like would have been predicted by rational choice models they would’ve earned about 10% more for the same hours of work.

So why do the cabdrivers behave this way? The likely answer is that they show something called reference dependence, they have a goal for each day’s earnings and they are satisfied if they earn more than that goal but disappointed if they earn less.

They work into it to earn more than the reference point and then they stop. By thinking about each day in terms of a target reference point the cabdrivers ensure they earn their desired pay, even if they aren’t efficiently allocating their time in the way predicted by economics.